November 11, 2007

Banking crisis set to worsen

We may not feel it in our pockets yet, but the US sub-prime crisis is coming to a bank near you.

The New York winter uniform of stifling high turtlenecks, outlandish earmuffs and quilted jackets is back. So too are the hundreds of Irish shoppers who will spend more than half a billion dollars in the city before Christmas. The city is bracing itself for the big spending season – but all is not well.

Up in the theatre district, where Conor McPherson’s brilliant play, The Seafarer, is previewing to packed houses, the glitz of showland is competing with the ticker tape of Wall Street for the attention of New York’s commuters. The news flooding in from the financial district is unambiguously deflating. New Yorkers, so tied up – via their 401k investments – in the stock markets, are worried. And why wouldn’t they be?

The banking crisis, which was supposed to be limited to the delinquent sub-prime market, is spreading rapidly – not just here in New York, but across the pond in London.

Last Friday morning, Barclays Bank – the third-biggest bank in Britain – saw its share price fall 10 per cent, following rumours of a $10 billion write-down on bad loans. (Barclays denied the rumour, but this follows the pattern of the past few months where the banks initially deny that there is a problem and then drip feed bad news to the markets, only to finally put their hands up and admit serious financial problems.)

Irish banks, already down some 40 per cent this year, have also seen their share prices hammered. Anglo Irish Bank, the darling of the property boom, is among those to have had share prices hit.

The credit crisis is moving from continent to continent, and the barriers between what most people are prepared to believe and the stark reality are narrowing steadily. In the past few days, banks around the world – even Swiss ones – have been queuing up to announce larger write-offs and increased losses from sub-prime debt instruments, in many cases before the ink has dried on the announcements of their original estimates of these losses.

More than anything, this rapid reversal has demolished the facade that the sub-prime disaster was a) small-scale, b) localised by industry sector and/or by geography, and c) something that would only affect earnings and share prices for, at most, a couple of quarters.

Instead, we have major institutions doubling and tripling their estimated losses – and firing their chief executives and other senior honchos. Let’s leave aside – for the moment at least – the absurdity inherent in this ritual whereby people who received huge pay packages because of their supposed managerial skills, but who failed in their jobs, are ‘awarded’ packages worth millions, often tens of millions – and for chief executives sometimes in excess of $100 million – when they are sent packing.

Usually, when a firm admits its stored-up losses and fires its boss, the markets react positively, reasoning that the boil has been lanced and the body will now recuperate.

But that is not the case now. Shares in the financial sector are being remorselessly pummelled because market players are absorbing the shattering realisation that there is not going to be a quick fix to the so-called ‘sub-prime crisis’ – because there is no such quick fix.

On the contrary: the estimates of total losses of $150-200 billion, which as recently as August were considered wildly pessimistic, are now mainstream. Since the first round of write-offs by the world’s (and especially America’s) biggest banks amounted to only $20 billion, and the second round may take us to the $50-70 billion level, it’s not hard to see why investors are now either in shock or in panic.

Against this background, it is hardly surprising that the unthinkable has become thinkable and then writable, and thus onto being the hot topic. Take Citibank: the question is not who the next chief executive or chairman might be, but whether the largest financial institution – also one of the biggest employers in the IFSC – will survive in its current shape.

The issue is not whether Citibank might go bust: hefty though its losses are, they are nowhere near that magnitude. What is being talked about in New York is whether it is possible, or even desirable, to allow this mega-institution to lumber on, or whether it would be better to break it up into the components from which it was assembled – investment banking, commercial banking, asset management etc.

Outlandish as this proposition might seem, this is what happens in credit crises. On the way up, banks buy each other, merging departments and activities. On the way down, the very gelling agent of the merger – profits – disappears, and the merged entity falls apart at the seams.

In New York, this process is taken for granted. If indeed, $150 billion in capital is going to be wiped out because of sub-prime losses – Nuriel Roubini, (www.rgemonitor.com) the number one global bear on this issue, now estimates $238 billion from sub-prime alone and double that from all sources – then many big names are going to be expunged entirely, shrunk severely or find themselves under new ownership.

In Ireland, we tend not to think this way because, up until now, banking crises have been bailed out by the state (AIB in the 1980s).This time around, if patterns in the US are anything to go by, Irish bank losses – in property alone – are likely to be enormous.

Investors have already sensed this; I’m not too sure that the rest of us have. But this has all happened before. In Norway and Finland in the early 1990s, the state had to raise government bonds equivalent to 10 per cent of GDP to bail out their banks. Could this happen here? Would it happen here?

Or might it be preferable to simply let the market do its thing? This would imply allowing share prices to fall more, making the banks attractive to a foreign takeover. A big shake-up in the Irish banking sector is the likely outcome of the credit crunch.

That is the easy part to understand, once you are prepared to think about it. But because these are banks – and as with their American counterparts, their loss of capital means they will be forced to lend less – the whole structure of the Irish economy, which has been built on ever-increasing amounts of debt, will be shaken to the core.

So far, the crowds of Irish shoppers — armed with their credit cards – streaming off the Aer Lingus planes at JFK are carrying on oblivious. But as Irish bank shares plummet, the realities of the global financial markets are only a shopping trip away.

Was interesting reading this piece in the Sunday Business Post yesterday … not buried, but well at the back (can’t remember seeing the usual plug that you get on the Front page!)

On the same edition, front page (below the fold, but still front page) they had a property ‘expert’ from the US (a professor no less, but no other credentials given) state that prices here had dropped by all that they were going to drop, and that any more reductions would be a ‘travesty’.

Now I now that everybody writing for the SBP doesn’t hang out in the local discussing their articles before they submit. But if they ever do, can you let us know? I’d pay to see that discussion :-)

I have friends whom work in Citibank and they are really getting worried about the credit crunch

It was expected of course, people in this country were borrowing amounts of money that they had no hope in hell of ever paying back……realistically

The Builders in Dublin & Across Ireland got fat off the overinflated houses half of them rushed and I hope they personally are buried in their own rubble for the misery and stress they have caused the honest joes who work hard and spend every hour gods sends paying off their never ending mortgage.

Another reason why trouble will hit us the hardest is because we are the bridge between America and Europe, billlions and billions of dollars have been invested in this country and it appears most it was borrowed from shady people in the states.

This excludes the money from the EU that we have blown foolishly on some stupid schemes e.g. Decentralisation.

America has a GDP of $12 Trillion a year and they are 4 times this amount in debt!!!!

That is the worst they have ever been, they hardly in much debt when 1929 happened.

Welcome to the biggest economic depression we’ll ever know, the 21st Centuary Crash is coming to your nation and soon

I can see it now, the Foxrock mafia of property developers with their blacked-out windowed four-wheel drives will be forced to sell everything and have to move back to rented 3-bedroomed semis, their over-privileged Lyndsey Lohan cloned progeny will have to go to state schools for the first time in their lives, Mount Anvil and the Wesley cattle market for spoiled brats… I mean Disco… will be forced to close down (finally!) And as the poor Tiger lets out it’s last pathetic whimper, Brown Tommy’s will be bought out by Benjamin Dunne and turned into the flagship store (of course by then, the ridiculous rents in Graft On Street will have collapsed) and the hottest word in D Four will be “Emigration.”

Much of the leverage employed was borrowed from the large investment banks and the first thing those banks did in June was to make margin calls, Bear Stearns notably, but there were others.

This forced hedge funds to liquidate their securities and put further downward pressure on the prices of securitised products(mortgages).
So it looks like “Paddy last” are the banks, the monoline insurance companies, Governments, councils, local authorities and maybe even YOU though your pension fund.

Remember most of the people in Hedge funds used to work at banks….they aren’t that different.

David said:
“In Ireland, we tend not to think this way because, up until now, banking crises have been bailed out by the state (AIB in the 1980s).This time around, if patterns in the US are anything to go by, Irish bank losses – in property alone – are likely to be enormous.”
I did not think irish banks (B of I,& A.I.B.) were heavily exposed to the american sub prime scene/ dodgy derivitive/bond markets. Do they really deserve their present punishment on the stock market? I cannot see a glut of re-possessions on the irish property market as a coming scenario-at least in the short term.

Factor in higher income tax, this may not be introduced in this budget but it the economy keeps going down hill it will have be introduced on the next budget. Taking a look at industry at the moment all manufacturing plants are shutting down (RTE today reminded me of scences from the 1980s) and IT companies are desperately looking for people but the salaries they are offering are very low and there is no way you can survive on it and raise a family.

Looking at RTE today, I see the transportation is in a right mess with 7 hours travelling from Sligo to Dublin. I’m able to travel from London to Paris in under 2 hours. Only one word for it ridiculus. It’s obvious there is going to be a recesiion in Ireland and if you don’t see it then you need glasses. Also because we have no proper services or infrastucture a recession will hit the country very very hard.

I’m already living and working in London city and I will see the rest of you over here this time next year. :-)

This is the start of a global recession akin to the great depression of the 1930′s. London is going to get hammered by the fallout from the financial sector.

The next decade is going to be very rough and will likely culminate in a new world war as the American empire disintegrates. The reason we will have a depression is both the Americans and Asian economies will collapse at the same time, however China will emerge the stronger power in years to come. Most modern recessions last 5 years from peak to trough, this one will last longer.
Nobody in 1907 (There was a banking crises then as well) would have predicted that in 7 years would have predicted the great war of 1914-1918 and subsequent rise of the USA as a global power on the back of this. The parallels between today and then are uncanny, but as human nature does not change then neither does the outcome.
The last years of the boom were not funded by savings of Irish people, but on debt borrowed from abroad, debt that has also been securitized abroad meaning money will haemorrage out of this country. We’re broke and we now have to get down to the business of fixing the balance sheet.

Ray, that scenario is terrifying. Unfortunately it is very likely to happen. I think the coming recession could make the Great Depression look like a storm in a teacup. Apparently the Americans are testing new weapons which can be fired from a hypersonic plane because they are afraid of China’s capabilities. They’re at nothing. Unlike the gung-ho Americans, China prefers to fight quietly and win its wars by stealth. If you want to see what I mean, go down to your local convenience store. Who is running it? Were they there 10 years ago?

We Irish have a mindset that hard work isn’t always rewarded and this is partly because of our history and government policies. The Chinese don’t think that way. They don’t like getting into debt either. They think long term and don’t plan their policies in terms of the next election.

Anyone who works hard, makes sacrifices and saves money deserves to be successful, no matter where they come from. In the meantime, perhaps we should start learning Mandarin or Cantonese.

The thing about sub prime doesn’t mean a bank has to be the lender to someone who can’t pay it back. The sub-prime debt was repackaged and traded in. These were showing good returns for a while. Do we really believe the brokers in Irish banks were not lured by the tasty returns that these CFD’s or whatever they are called. Debt was turned into a commodity.

The sub-prime was packaged into CDO’s (Collateralized Debt Obligation). Basically each traunch is made up of good rated bonds (AAA), the next traunch with medium rating (BBB) all the way to the default rating (Sub-prime). Since one bond consists of many traunches this gave the ratings agency a hard time in trying to attach a rating. The trick was to have 20% of the bond as AAA rating and then the rest as D rating. When the ratings agency saw the first traunch of AAA rating then they gave the bond a rating of AAA, this is what has caused the problem because fund managers can only hold a certain percentage of there portfolio in the form of equities and with interest rates at an all time low, you don’t want to leave the rest for cash and also the government bonds would be trading high in price to give a low yield. The only other bonds that were giving a higher return but at a rating of top grade were the CDO’s. So a lot of fund managers moved in and bought a lot of CDO’s for there portfolio. We still won’t know the full extent until another year.

It’s like being food poisoned, the only way to recover is to let it go through your system and hope that your immune system can cope :-)

Hi Glen
The problem with sub-prime may well go a lot further than CDOs. The problem with most ‘sophiticated’ structured investment vehicles, is that no one really knows the level of leverage employed. The most sophisticated investment vehicles can achieve over 99% leverage – I was chatting a very large London based company who were proudly telling me about just this, about 18 months ago. So, take your ‘AAA’ CDO, and use it as collatoral to borrow….. how much? Even though the ‘how much’ is based on the value of the CDO, the ‘how much’ is the amount of money that was injected into the economy by the transaction.
It could get even worse: the new investment vehicle that was created by this borrowing against the CDO, can itself be sliced up, mixed with bits of other vehicles, and used to borrow even more money. As I understand it, this is where the ‘hedging’ comes in: Select your underlying vehicles in such a way that the risk of one part balances the risk of another part, and do it in such a way that the benefit of massive leverage creates a huge capital gain. Using highly sophisticated computer programs, probably representing the risk of each vehicle as a non-linear equation (I’m just guessing here, just guessing why they need the computers!). They’ve been able to ‘solve’ these masses of equations in some way or another, to create a new vehicle where the combined risk is deemed lower, so the value is therefore higher. They then leverage the bejesus out of, and then sell to fund managers who probably have about as much idea as I do, as to what they’re buying.

The problem is the risk. Given the complexity, no one really has any idea as to what might cause these huge edifices to fail. Given the leverage, the failure of a few comparatively small components could lead to a huge value of investments becoming valueless. Or not.

Two thoughts haunt me on this: Firstly is the collapse of Barings bank. Barings bank collapsed, essentailly, because of the Kobe earthquake. Secondly is the fact that all these clever bankers have no downside to what they do: in a year when their fund rises and their investors do well, they receive their multi million pound bonuses; in a year when their fund falls and their investors lose money, they just don’t get a bonus. If a bad year follows a good year, and the fund is worth the same at the end of 24 months as it was at the beginning, the bankers still have their first year bonuses. This must effect their judgement.

As I read this article from just 13 months ago it is easy to see that even the worst case scenarios would have been acceptable. It has been an awful 2008 for the financial world and no signs of improving yet.

My favorite piece of the article predicts that “…many big names are going to be expunged entirely, shrunk severely or find themselves under new ownership.”

Travelling to JFK is about to end for the middle class looking for bargains. Russian and Chinese businesses are beginning to default on repayments to european banks. The amounts owed to Swiss and German banks in artyicular from investments in these developing countries is MASSIVE. Demand for oil and chinese products are cratering and the euro will be an immediate victim of this fact starting January 1.

I sure hope the irish pension fund is insulated from any such defaults and the resulting fall in the euro….!